Don’t let the title of this paper scare you away. While the authors have no hesitation in describing their work as taking on some of the “metaphysical" questions that confront monetary economics, that’s just the icing on this excellent cake. You could leave the icing alone if it doesn’t agree with you.

Patra and Kapur give a lucid account of the changes in fashion that monetary economics has been subjected to in the last few decades. After dwelling on the history of the subject, they turn their attention to the “regime changes" that have occurred in monetary policy in India. They say a working consensus has emerged in India over the conduct of monetary policy, a consensus labelled the New Neoclassical Synthesis or the New Keynesian model. The authors explain it clearly: “Inflation and output respond to aggregate demand, aggregate demand to interest rates, and interest rates are set by monetary policy, in turn, in response to expected movements in inflation and output." They say while money plays no explicit role in the policy, it has a central but unseen role in the entire process. Hence the very intriguing title of their paper.

So what does this new Keynesian model tell us about the conduct of monetary policy in India? Most important is perhaps the authors’ conclusion about the Reserve Bank of India’s most recent policy measures. The paper notes that the central bank has been following a policy of “calibrated" monetary tightening since January this year. Has the tightening been enough? If not, how much more tightening needs to be done? The authors state clearly that “the estimated neutral policy rate defined in terms of the GDP deflator is still around 75 basis points above the effective policy rate prevailing currently. This is the indicative amount of further policy tightening that appears to be warranted to normalize the policy stance in view of sustained inflationary pressures and the narrowing of the output gap". In other words, RBI is still behind the curve.

Should the central bank tighten sooner or later? The paper finds that the lag between a change in the interest rate and the impact on aggregate demand in the economy is at least three quarters. Moreover, given the presence of institutional impediments in the credit market, this lag could go up to two years. The authors say this lag is why banks are slow to respond to changes in the policy rate by RBI. In other words, monetary policy should be anticipatory, thus calling for rapid rather than incremental tightening when needed.

This conclusion is reinforced by the authors’ finding that inflationary expectations tend to persist. Consequently, say the researchers, “Monetary policy needs to be wielded in an agnostic manner that nips in the bud— to use an old cliché—any inflationary impulses that are deem- ed to be more than transient."

The authors also say fluctuations in agricultural production should not be seen merely as supply-side phenomena about which monetary policy can’t do much, but should take into account their impact on aggregate demand. They point out the increasing impact of external influences in the assessment of aggregate demand and the importance of global commodity prices on inflation. They also argue that targeting the exchange rate as a means of controlling inflation doesn’t work for India.

But the crux of their message is this: “The findings of this paper support a forward-looking response of monetary policy to expected inflation and output dynamics in India. Transmission lags, which are consistent with the cross-country empirical evidence, highlight the importance of being pre-emptive for effective macroeconomic stabilization, and, thereby, credible."

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